The benefit of participating in the S&P 500 Index is evidenced by the impact of the share price of Franklin Resources, which was chosen to replace CoreStates in the index following the latter’s merger with First Union Bank. On being added to the index, Franklin’s share price moved up substantially as the index players ploughed into the stock (with the stock price moving in a 52-week range from $25.50 to almost $53).

Most investors erroneously consider indexing to be synonymous with S&P 500 indexing. So when large-cap stocks begin to underperform, so will their index funds. Investors might assume that an indexing strategy no longer works and are likely to desert their S&P 500 Index funds in favor of a more active management style (which also include smaller stocks), bringing large-cap stock prices further down as portfolio managers are forced to liquidate to meet redemptions.

But the poor performance of the S&P 500 Index funds cannot be attributed to indexing. The index funds would underperform because of their large-cap focus, not because of indexing. The fact of the matter is that indexing works in all markets. An indexed portfolio of small-cap stocks will, on average, perform better than an actively managed small-cap portfolio. "I see small and mid-cap indexes doing very well. If I were to make an investment recommendation, it would be S&P SmallCap 600 Index funds," says Mr. Evans of Galaxy Mutual Funds.